Sharpe Ratio : Basics, How to use it and More

Sharpe ratio is used to evaluate the risk-adjusted performance of a mutual fund. Basically, this ratio tells an investor how much extra return he will receive on holding a risky asset.

What is Sharpe Ratio?

Sharpe ratio comes very handily to measure the risk-adjusted returns potential of a mutual fund. Generally, risk-adjusted return happens to be the returns earned over and above the returns generated by a risk-free asset like a fixed deposit or a government bond. The excessive returns are viewed in the light of the “extra risk” which an investor takes upon investing in a risky asset like equity funds.

The risk inherent in an investment is determined using the standard deviation. Thus, a higher Sharpe ratio indicates better return yielding capacity of a fund for every additional unit of risk taken by it. It becomes a justification for the underlying volatility of the fund. In fact, you may use the Sharpe ratio to compare the funds.

How to calculate Sharpe Ratio?

You can quickly locate the Sharpe ratio in the fact sheet of a mutual fund. The Sharpe ratio is calculated by subtracting the risk-free return from the portfolio return; which is known as the excess return. Afterwards, the excess return is divided by the standard deviation of the portfolio returns. It is used to measure the excess return on every additional unit of risk taken. Generally, it is calculated every month and then annualised for easy comprehension.

It is calculated using the formula given below:  

Sharpe Ratio = (Average fund returns − Riskfree Rate) / Standard Deviation of fund  returns

It means that if the Sharpe ratio of a fund is 1.25 per annum, then the fund generates 1.25% extra return on every 1% of additional annual volatility. A fund with a higher standard deviation should earn higher returns to keep its Sharpe ratio at higher levels. Conversely, a fund with a lower standard deviation can achieve a higher Sharpe ratio by earning moderate returns consistently.  

What is the Significance of Sharpe Ratio?

Sharpe ratio indicates investors’ desire to earn returns which are higher than those provided by risk-free instruments like treasury bills. As Sharpe ratio is based on standard deviation which in turn is a measure of total risk inherent in an investment, Sharpe ratio indicates the degree of returns generated by an investment after taking into account all kinds of risks. It is the most useful ratio to determine the performance of a fund and you, as an investor, need to know its importance.

A Measure of Risk-adjusted Return

Sharpe ratio is a comprehensive mechanism to ascertain the performance of a fund against a given level of risk. The higher the Sharpe ratio of a portfolio, the better is its risk-adjusted-performance. However, if you obtain a negative Sharpe ratio, then it means that you would be better off investing in a risk-free asset than the one in which you are invested right now.

Measure for Fund Comparison

Sharpe ratio can be used as a tool to compare funds placed in the same category as analysing the performance of Fund A and Fund B, which are large-cap equity funds. In this way, you will ensure that both the funds are facing a similar level of risk. Conversely, you might compare funds giving the same returns but which are at different levels of risk.

Measure for Comparison Against the Benchmark

Sharpe ratio can tell you whether your preferred fund is suitable from an investment perspective as compared to peer funds in the said category. You may even broaden your horizon by comparing the fund’s Sharpe ratio with that of the underlying benchmark.

In this way, you get to know whether your fund is outperforming/underperforming the benchmark. Ultimately, you get to know how well are you being compensated for the risk that you are taking in the investment.

How is Sharpe Ratio used to select Mutual Funds?

Analyse Fund Strategy

Sharpe ratio is one of the most powerful tools used in mutual fund selection. As it is entirely quantitative, it provides objective feedback into the fund’s performance. By looking at the Sharpe ratio, you can assess the degree of risk that two funds faced earning extra returns over the risk-free rate. It is a standardised tool to compare funds which use different strategies like growth or value or blend.

Optimum Risk-Return Tradeoff

Ideally, you might consider a fund desirable which has a higher Sharpe ratio. However, this kind of perception may not always be fruitful if the fund took a lot of additional volatility. It means that a fund that achieves 7% returns with moderate volatility will always be better than a fund which gives 8% returns with a lot of ups and downs. A higher Sharpe ratio, thus, means that the relationship between fund’s risk and return is ideal.

Examine Portfolio Diversification

You may use the Sharpe ratio to identify whether the new fund which you want to add to your existing portfolio would be beneficial or not. Suppose the current Sharpe ratio of your portfolio is 1.15. Ideally, the addition of an extra fund should increase the Sharpe ratio by lowering the overall risk and boosting the returns. On the contrary, if the Sharpe ratio drops to 1.05, then it indicates that you need to revisit the decision of diversification, i.e. adding that fund to the existing portfolio.  

What are the weaknesses of Sharpe Ratio?

However, there are certain precautions that you need to take while using the Sharpe ratio. Firstly, it is just a number and standalone it conveys lesser meaning. You need to compare the Sharpe ratio of two funds to derive its exact meaning. Sharpe ratio does not account for portfolio risk. It does not indicate whether the portfolio is concentrated in a single sector.

Suppose a fund is made of only technology stocks and sector performs well. The fund’s Sharpe ratio will be very high, but simultaneously it will be a risky proposition for an investor looking for moderately risk investment. Hence, it would help if you did not blindly rely on Sharpe ratio for shortlisting a fund. You may use other qualitative measures along with this ratio for informed decision making.

Finally, it is always desirable to use Sharpe ratio keeping your investment horizon in focus. Usually, you will find the Sharpe ratio indicating three years’ risk-adjusted-performance. But if you have a long-term investment horizon, such ratio might seem irrelevant.  

Conclusion

Many times investing in mutual funds becomes complex. In case you don’t possess enough financial knowledge and are finding it too difficult to understand, then log on to ClearTax Save. Here, our financial experts use financial ratios to provide you with the best funds in which you can invest in a hassle-free and paperless manner.